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| rate of return over a given investment period |
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| portfolio choice among broad investment classes; most important part of portfolio construction (risky vs. risk-free assets) |
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| plot of risk-return combinations available by varying portfolio allocation b/w a risk free asset and a risky portfolio |
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| reward to volatility ratio; slope of CAL; shows extra return per risk beared |
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| adding assets to a portfolio in order to reduce some of the market/systematic/non-div risk |
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| measures portfolio risk (which depends on correlation b/w returns of assets in portfolio); if + covariance stocks both either performed well or poorly; if - then some stocks did well and some did poorly |
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| interprets magnitude of covariance (-1 to 1) |
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| investment opportunity set |
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| set of available portfolio risk- return combinations |
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| graph representing set of portfolio's that maximizes e(r) at each level of portfolio risk; set of efficient portfolios |
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| portfolio choice is 2 independent tasks: 1. determine optimal risky portfolio and 2. personal choice of best mix of risky portfolio and risk- free asset; #1 is same for everyone |
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| model to estimate components of risk (market and firm- specific) for a particular security/portfolio; Sharpe was first to use this |
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| rate of return in excess of risk- free rate; Ri= ri-rf |
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| sensitivity of returns to mkt factor (market/systematic/non-div risk)- so it measures the influence of the market on stock return; measures the slope of the SCL; normally b/w 0-2; |
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| stock's e(r) beyond what's induced by the market; tells out/under performance relative to the CAPM; avg firm- specific return; + alpha= underpriced & outperforms market (above the line); - alpha= overpriced & underperforms market (below line); represents the intercept |
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| security characteristic line |
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| plot of security's excess returns (Ri) as a function of the excess return of the market |
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| model that relates the required rate of return for a security to its risk as measured by beta; assumes: 1. investors are price takers and have identical beliefs, 2. only one planning period, 3. all assets are traded, 4. no taxes/transaction costs, 4. fixed supply of assets |
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| portfolio for which each security is held in proportion to its market value (where everyone will choose to invest) |
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| all investor's desire same portfolio of risky assets and can be satisfied by a single mutual fund composed of that portfolio (market portfolio) |
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| expected return- beta relationship |
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| since non-systematic risk is diversified away, investors require a risk premium for compensation for bearing systematic risk, and that risk premium should be proportional to its beta (which measures the systematic risk); this relationship is graphed as the security market line |
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| graphs the expected return- beta relationship; slope= RP of mkt port; graphs independent asset RP's as a function of asset risk; provides required rate of return that will compensate investors for risk of that investment |
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| graphs RP's of efficient portfolios as a function of portfolio standard deviation; CAL w/ the highest S ratio (where everyone will try and invest) |
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| models of security returns showing that returns respond to several systematic factors (vs. just mkt & firm- specific risk) |
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| stock price changes are random and unpredictable |
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| efficient markets hypothesis |
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| hypothesis that prices of securities fully reflect available info about securities |
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| prices reflect all historical info; implies trend analysis is worthless |
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| semi- strong form efficiency |
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| price's reflect all publicly available info; implies fundamental analysis is worthless |
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| prices reflect all available info, including insider info |
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| search for patterns in stock prices |
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| resistance vs support level |
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| price level where unlikely for stock to rise above/fall below |
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| uses earnings, expected interest rates, and risk evaluation to determine stock prices |
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| passive investment strategy |
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| buy well- diversified portfolio w/out trying to find mispriced securities |
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| poor/good performing stocks in one period continue that abnormal performance in following periods; suggested in short- medium time horizons; (short- run momentum); tests weak form EMH |
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| stock returns related to past returns |
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| tendency of poorly- performing and well- performing stocks in 1 period to experience reversal in the following period; suggest stock market overreacts to relevant news; long run reversal- returns over long horizons suggest negative long- term serial correlation; tests weak form EMH |
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| variables/events that predict returns (& that contradict the EMH); anamolies are semi-strong tests; ie: post- earnings ann drift, day of the week effect |
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| mkt anamoly; port's of low P/E stocks have higher average risk adjusted returns than high P/E stocks |
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| mkt anamolie; stocks of small firms have earned abnormal returns, esp in january |
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| mkt anamoly; investor's in stocks of less well-known firms to generate abnormal returns |
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| mkt anomaly; investor's in firms w/ high B/M value generate abnormal returns |
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| post- earnings annual price drift |
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| mkt anamoly; abnormal return (+ or -) on the earnings announcement day; continue to rise/fall after announcement day and then adjust gradually |
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| PV of firm's expected future net CF's discounted by the required rate of return; if intrinsic value > mkt value--> stock is undervalued & a good investment |
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| formula for intrinsic value of a firm = to the PV of all expected future dividends |
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| plow back ratio/ earnings retention ratio |
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| % of firm's earnings that's reinvested in business (& not paid out as dividends) |
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Definition
| PV of firm's expected future net CF's discounted by k (requ. r. of r); if intrinsic value > market value- BUY (undervalued, + alpha, good investment; if < mkt value- SELL (sell if + holdings; sell short if 0 holdings) |
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| market capitalization rate |
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Definition
| mkt- consensus estimate of the appropriate discount rate for a firm's CF's |
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| alternatives to finding cost of (equity) capital |
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| 1. CAPM; 2. industry avg cost of cap; 3. implied from DDM; 4. survey investors/CFO's; 5. multiple risk factors |
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| premium investors demand for investing in an average risk investment, relative to the risk- free rate (in excess of risk- free rate); increases w/ risk aversion; --> in regards to SMB, RP is return difference b/w small and large stocks; in regards to HML risk premium is diff b/w value and growth firms; in regards to MOM, RP is return diff b/w past 6 mos. winning and losing stocks |
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| high P/E; low dividend yield; high growth; low B/M; historical sales growth > 10% |
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| low P/E; high B/M; high dividend yield; low growth (sales growth < 10%); better performance than growth stocks (higher return on avg) |
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| size (in regards to style box) |
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Definition
| large vs. small cap firms; SMB (small minus big)- there's a premium for holding small cap stocks over big cap; measured by pr x # shares outstanding |
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| value- growth (in regards to style box) |
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Definition
| HML (high minus low)- there's a premium for holding a value stock over a growth stock; measured by B/M ratio; value stocks have high B/M and growth have low B/M |
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| ways to estimate risk premiums |
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Definition
| 1. survey investors; 2. historical data; 3. estimate implied premium in today's asset price |
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| historical premium approach (to measure risk premium) |
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Definition
most common approach: 1. pick a time period for estimation; 2. calc avg returns on a riskless security over that time period, and then avg returns on an index, and 3. find diff b/w the two and use as your premium
limitations: assumes risk aversion hasn't changed; assumes riskiness of 'risky' portfolio (st. index you're tracking) hasn't changed in mkt risk over time |
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| implied equity premium approach (to measure RP) |
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Definition
use a basic discounted CF model to estimate implied risk premium from current price levels (forward looking estimate)
limitations: must use correct DCF model; all inputs (like expected growth/dividends) must be correct; implicitly assumes market is correctly valued |
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| firm is in stable growth; grows at a constant rate forever |
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| ways to estimate growth in earnings |
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| 1. look at past; 2. look at what others are estimating (ROE x plowback); 3. look at fundamentals (how much firm is investing in new projects and what returns those projects are making for the firm) |
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| measured by the standard deviation of stock returns; higher volatility, higher risk; small stocks are the most volatile; volatility is not constant over time |
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| a state in which the volatility of a security changes at a low rate; shown on distribution curve w/ fat tails- (black swan: statistically unlikely to happen, but it does) unusual returns and unexpected stock prices |
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(VIX) tracks volatility index, calculated from S&P 500 option prices
(BXX) buy/sell volatility; calculated from nasdaq 100 option prices |
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| due to firm- specific risk; movements in returns, firm- specific volatility- how the stock does after you control the market aspect |
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| total influence of the market on the stock; the way the portfolio moves w/ the market; component of return due to movements in the mkt index |
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| optimal risky portfolio; all investors will have identical beliefs, so they will all want to hold the same risky portfolio |
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| momentum (in regards to style box) |
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| MOM (high minus low momentum) |
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| highest return for a given volatility; set off efficient portfolios will be on the efficient frontier |
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| standardized unexpected earnings; part of the post- earnings announcement drift (price tends to drift in direction of the surprise for about 90 days |
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| lots of cash to buy stocks with; ie: investment mgmt; mutual funds like Vanguard/Fidelity |
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| sell to buy- side; ie: investment bankers like Merrill Lynch |
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| how much of the volatility of the stock is explained by the volatility in the market (model if using in regards to 3 factor model); higher the correlation, higher the r squared |
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